A Plan to Junk the Income Tax

Michael Graetz, a Yale University law professor, has a dream shared by million of taxpayers: an America where April 15 would be just another spring day. In his book 100 Million Unnecessary Returns: A Simple, Fair, and Competitive Tax Plan for the United States, Graetz outlines a plan to eliminate the income tax for most Americans. He would replace it with a value-added tax that would be levied on goods at each stage of exchange, from the producer to the consumer. U.S. News talked with Graetz about why he believes his plan would make Americans' lives easier and be a better deal for the country. Excerpts:

What are the basics of your plan?
The idea is to enact a value-added tax and use that money to create an exemption for families with less than $100,000 of income in the income tax. You only pay taxes on the amount above that. It lowers the individual tax to 20 to 25 percent, and it lowers the corporate tax to 15 to 20 percent.

The system I'm talking about is basically the system that the U.S. had until the Second World War. It had an income tax that only applied to high-income individuals, and it had a tax on consumption. It was a bad consumption tax because it was in the form of tariffs. We know now that tariffs are harmful to the economy.

But now there are 142 countries around the world that have value-added taxes. We know they work. Although we're a low-tax country overall—much lower than Europe or elsewhere—our income taxes are not low. Our corporate tax is, for example, the second highest in the world. And the reason for that is because other countries tax goods and services with value-added taxes. We don't, so we're not taking advantage of our status as a low-tax country because the income tax is too high.

What's wrong with the income tax?
It's hopelessly complex. It's badly broken. There are, for example, seven different savings [plans] for higher education. If you use some of them, you can't use others. No one can know what's to their advantage without doing a ton of calculations.

Americans are spending $150 billion a year just on the time spent compiling the income tax. That's just waste. We're not producing any goods or services.

The current system, which has its phase-ins and phaseouts and terminations in 2010, is completely unstable and unpredictable for people. Here's an example of that: Current law about the estate tax this year has a $2 million exemption. Next year it has a $3.5 million exemption and a 45 percent rate. In 2010, it's repealed altogether. In 2011, it has a $1 million exemption and a 55 percent rate. That's a crazy system that Congress has to do something about.

Wouldn't a flat tax solve these problems or complexities?
The complexities are not due to having more than one rate. They are due to all the tax credits and deductions. One of the great advantages of my plan is that it solves the problem that I call the chicken soup problem. My mother would always say that whatever illness you had, the solution was chicken soup. The politicians say that no matter the economic ill, the answer is an income tax credit or deduction.

If you just look at this week's housing bills in the Senate, the Congress is looking to put in new credits for property taxes and new deductions for home builders. We know from our history that these things are not genuine solutions. We give tax breaks to companies that provide health insurance, and we have the most uninsured people and the most rapidly rising health costs in the world. Yet Republicans and Democrats alike all rush to do some sort of tax incentive.

Why a VAT?
The reason a VAT is good for economic growth is that it allows countries like Ireland and Hong Kong to have low income taxes. It's the low income taxes that are good for economic growth. The VAT doesn't tax savings and investments, so it's not as burdensome on the economy.

The idea is to make the U.S. a very favorable place for both U.S. companies to invest and for people around the world to invest in productive activity. That will produce jobs. That's one of the main reasons lowering the corporate rate is so important. Right now, if you come to the U.S. to build a plant, you pay a corporate rate of 35 percent.

People criticize the VAT for being a hidden tax, so it is easy for politicians to increase. Would a VAT inevitably lead to higher taxes?
My proposal responds to that argument by using the VAT to lower income taxes. If you have a $100,000 exemption, no congressman is going to say, "Let's lower that exemption to get those people back in the income tax."

There's some mythology about the ever increasing VAT. Canada has reduced theirs since it was enacted.

Many politicians suggest that what we need to solve revenue problems is to just raise taxes on high-income people.
I don't think we have a need for more revenue in the short term. In fact, we may need lower taxes in the short run if we're in a recession. But because of the aging population and the rise in healthcare costs in coming decades, we're going to have a fiscal problem that will require the government to take a hard look at what it is spending and cut spending in some instances, and we will need to look how to cut spending and will also require higher revenues. The plan puts in place a system where you might be able to get those revenues without courting economic disaster.

The current system does not have much room in it for higher revenue. You can't raise corporate tax rates in the current international economy without harming businesses and workers. The increases in tax rates at the top will produce some revenue, but they don't produce the kinds of revenue that deal with these problems.

In 2040 or 2050, if nothing changes, we're going to have a tax system that can barely fund Social Security, Medicare, and Medicaid alone. Something has got to give. We ought to restructure the tax system now to try and get a more competitive economy and more economic growth.